News analysis

Banking in Britain

The Miles Higher club

THE Bank of England houses some of the most trenchant critics of Britain's big banks. In most countries policymakers are broadly satisfied with the new Basel 3 accords, which govern the size of firms' capital buffers. But top officials at the bank, including its governor, Mervyn King, and Andrew Haldane, have criticised the rules as being far too puny.

Joining them is Professor David Miles, a heavyweight economist who once worked at Morgan Stanley and is now an external member of the monetary-policy committee, which sets interest rates. In a recent paper with two other economists, Jing Yang and Gilberto Marcheggiano, he argues that banks should carry core equity ratios of at least 20%, more than twice the new Basel requirement. To put that in perspective, it would require the big five British banks to raise about £220 billion more equity—equivalent to a decade of profits at this year's run rate, or roughly an eighth of the value of Britain's stockmarket.

A Martian solvency specialist landing at Threadneedle Street might well judge that the degree of safety being debated there is bonkers. At a 20% ratio the five banks would have to carry some £438 billion of equity buffers to protect them against the risk of catastrophic loss. Yet during 2007-2009, the worst crisis in a generation or more, the peak loss they suffered was only £33 billion (excluding profitable firms, assuming HBOS remained independent and before tax and goodwill).

To get to these sort of figures Professor Miles and his colleague do a great deal of groundwork. They first estimate the cost to the economy of banks carrying extra equity. Professor Miles accepts that equity may be more expensive than the debt it replaces. The Modigliani and Miller (M&M) theory states the opposite, that in a tax-free world a firm's overall cost of capital should not vary according to its leverage. But the peculiarities of banks, including implicit state support, the ability to borrow freely from central banks at short-term interest rates that are typically below long-term rates, and depositors who are insensitive to risk, make it unlikely that the M&M theory holds true. That means banks would probably charge customers higher interest rates to compensate for their bigger equity buffers.

By way of illustration, Professor Miles estimates that a doubling of capital ratios to 17% would reduce the long-term level of economic output. The present value of the cumulative loss works out at between 2.6% and 6% of current GDP, depending on the extent to which the M&M theory applies and assuming that the taxes banks pay flow back to society. That bill must be set against the benefits of a safer system. Based on evidence since 1821 from a range of countries, the authors reckon that economic slumps are more likely than one might think. So for example a 15% drop in GDP should only happen once every 600 years according to normal models of probabilities, but in fact it seems to happen every 80 years. Comparing the cost of more capital against the value today of avoiding crises in the future, the authors reckon the optimal level of capital is over 20%.

Just how convincing is all this? Cynics reckon this kind of exercise involves torturing economic models until they confess what you want to hear. Analysts, meanwhile, point out that however pure the motives are, the high sensitivity of such models to the many assumptions used, which is amplified by the effect of discounting values over long time periods, makes the answer spat out pretty arbitrary. After all, the Basel club of regulators and the main banking-industry lobby group both did their own number-crunching exercise last year and reached quite different conclusions. Most civilians, finally, will recognise that the question being asked is abstract to the point of being philosophical: should we pay the equivalent of around a tenth of today's output in order to avoid a slump of, say, a sixth of output, of uncertain duration, at some point over the next half-century? You can almost hear the thuds as Britain's bank bosses head butt their desks.

Fortunately, there may be an alternative guide: real life. Professor Miles and his colleagues assume banks typically eat up capital as GDP drops. But the 2007-2009 crisis was not as simple as this. British firms in aggregate, and the global banking system, actually made profits over the crisis, that is to say they generated capital. Of course, most banks did benefit from government action to prop up asset prices. And there is no guarantee that in a future crisis the distribution of losses would be similar. All the same, the financial systems' actual experience during a recent severe crisis is surely more relevant than its hypothetical ones in parallel universes.

It is the very narrow skew of net losses that is the crisis's most striking feature. While the system as a whole was creating capital during the crisis, a small number of "outlier" banks consumed it. Perhaps five to ten large firms, out of a couple of hundred worldwide, suffered net losses that the new Basel standards would have been unable to deal with. This is why there is some substance to the British banks' view that being forced to run with 20% equity ratios, assuming equity is more expensive than debt, involves a degree of safety that bears no relationship with their actual experience.

The skew of losses is also why the Basel club of regulators and most international supervisors are less supine than their British critics seem to think. Their approach is to have capital standards that cover the vast majority of banks, and on top of that an extra layer of protection, which combined will get to about 20%, to deal with the tiny number of outlier firms that lose far more than average. The form that extra protection takes—discretionary capital surcharges, convertible bonds, or resolution mechanisms that put losses onto banks' creditors—may be less sturdy than pure equity, but the probability of a well regulated bank needing to use such emergency measures is tiny.

It is likely, although not certain, that these arguments will also eventually win the day in Britain. Still, there is a third way to deal with the problem of outlier firms that lose lots even as the system as a whole is profitable. That is to let banks get even bigger, so that those losses can be offset against profits elsewhere. It is safe to say that this one option that Professor Miles and his colleagues at the bank are not considering.

Oh, I have just realised the answer. Because if the banks could not borrow cheaply with a government guarantee and lend at exhorbitant rates to business and mom and pop, then they couldn't pay themselves tens of billions of dollars in bonuses. Now that wouldn't do for the club of the 'global elite' would it.

There is a very simple way to take care of this. No more bailouts, just protection for retail depositors. If you lend money to a bank you are a taking a risk and can as a bond holder lose money.

Banks would not be so keen to leverage up if they actually had to pay the unsubsidised price of debt. The rest of business gets by paying hefty rates to banks and so make careful investment decisions. Why should the banks not face the same market discipline?

Britain faces a bubble of fictitious confidence where undercapitalized banks defend a society made up of great expectations.

From the book “AN AUTISTIC WORLD (1)”

An asset bubble in not based on an illusion; it is founded in the interpretation of the truth by some individuals that consider the circumstances under a controlled environment, when in reality, their lack of knowledge or their private interest manage to form an indefensible situation. Usually those bubbles are created by the inability of removing barriers on time. They act more like dams than bubbles.

The Economist is an apologist for the banks. Even 20% would not have been enough to save the banks, but at least it is a step in the right direction.

If it was not for central banks buying toxic assets and allowing banks to mark assets to book value as against market value, the system and every bank would have collapsed. The crisis is not over, it has merely been delayed as the deleveraging process takes many years to play out. There will be great volatility and further contractions ahead.

The moral hazard of having a lender of last resort has to be eliminated before it is run. The lolr is entitled to compensation from those it covers, and that compensation ought to be the right to limit leverage actively when any market is getting tipsy on borrowed money. A fixed, or slightly adjustable, one-size-fits-all capital requirement is inadequate, especially if based on prior risk assessment (we it did so well, after all). Interest rates are too blunt and will cause far too much collateral damage if increased to slow an investment bubble that blows when the economy as a whole is not overheated. So the bubble will be left to blow.

Best of luck to the Brits still trying to put finance back in its proper place. Perhaps they will embarrass the Americans drafting new regulations enough to give them spine.

you continue to miss (or perhaps you go out of your way to avoid) the point.

So long as (a) banks are allowed to gamble, and (b) are backed by an implicit (actually now pretty explicit) bailout guarantee from the government, we have a problem.

I would be more chilled than San Miguel in Sevilla about how much capital banks need to hold if we removed (b) completely.

Equally if we have to keep (b), then I want to be very, very, very sure that the guarantee is unlikely to be called. And sorry, but asking a business that has long term assets backed by short term liabilities, to limit its leverage to 5:1 doesn't sound that excessive to me.

"Most civilians, finally, will recognise that the question being asked is abstract to the point of being philosophical: should we pay the equivalent of around a tenth of today’s output in order to avoid a slump of, say, a sixth of output, of uncertain duration, at some point over the next half-century?"

Fortunately, this report was NOT signed by either Mr. King or Mr. Haldane.

"The skew of losses is also why the Basel club of regulators and most international supervisors are less supine than their British critics seem to think. Their approach is to have capital standards that cover the vast majority of banks, and on top of that an extra layer of protection, which combined will get to about 20%, to deal with the tiny number of outlier firms that lose far more than average. The form that extra protection takes—discretionary capital surcharges, convertible bonds, or resolution mechanisms that put losses onto banks’ creditors—may be less sturdy than pure equity, but the probability of a well regulated bank needing to use such emergency measures is tiny."

So tiny is the Basel Club's and its Milesian apologists' understanding of human nature within their culture that their reports almost always ignore the specifics of how the shadow banking activity of derivatives brewing, peddling, and insurance, the boil of pus which eventually began bursting in 2007, was accumulated. It appears again to be reaccumulating, but this time not on real estate but on commodities. Isn't that what the G20, under France's leadership this year, needs to be again looking at?

Playing too many ethically irreconcilable roles as promoters, market makers, dealers, rating influencers, and bonus-besotted traders of exotic derivatives, some financial institutions are now engrossed in fending off the prying eyes of regulators, politicians, investors, and media responding to the outrage of voters around the world. It’s a game no one’s winning. Not only are the players under scrutiny. The regulators aren’t getting many plaudits either for bringing about what we ultimately all need: success in ending the ignorances and dishonesties that everyone knows are still, over three years since most pundits knew a crash was inevitable, going
on.

Moreover, if the financial sector, reckoned to include its regulators and political overseers, is sucking ever more out of the whole economy, what’s happening to the remainder? It’s getting
squeezed, of course. And that’s also worrying and not only because for many of us (The Economist does have readers who are not professionals in the financial field, does it?) the squeeze is too close to home. It’s also dividing us into “over-fed banksters” and “under-fed real people” and exacerbating social strife all around the world. Even worse, it’s making our transition as a
human species to a truly sustainable economy – one that’s fair, green, and thus able continually to change and prosper without calamities and catastrophes – even more challenging. Because what each of us wants to know about his or her little corner of the economy won’t stay still long enough for us to see it for what it truly is and get others to agree to some modest degree on our observations.

OK, we need to do something. So what’s all this about a new tax making sense if only political and financial leaders would wipe the windshields of their stretch Lincolns and Bentleys’?

Financial Derivative Contracts (FDCs) includes all financial assets that do not document a transfer of current title to a real economy good/service, are designed either to facilitate capital being matched to talent, labour, and -- let's not forget -- genuine LEADERSHIP in order to meet real human needs, or only to make money. Money, of course, is a potential good; but as we have seen a lot of recently, its spending isn’t always done wisely.

Thanks for your attention. If you voted with the 83% who yesterday were voting against the Economist's motion regarding the loving kindness of the world's "elite", whoever that might be, you will, I feel sure enjoy the paper of FDC regulation at the following URL:

Some of it´s th ability to keep trashing Sterling until trade picks-up. Some of it´s not having how ever many hundreds of thousands of unsold new houses. Some of it´s not having 20% unemployment. Some of it is higher wages and more of those jobs in the private sector. Some of it are large UK based/founded Co.´s other than banks Some of it are the many foreign Co.´s who choose the UK as their base for Europe... Some of it is no urgent need to overhall pension, labour relations etc. Some of it is a relative lack of corruption and efficient rule of law. Some of it is comparitively few politicians. Some of it is a long history of innovation and research.

So,
The bank of England is a stronghold of dangerous activists.
There are Martian solvency specialists landing in England.
Some must have worked at the Economist, it could explain the weird stories I have read in this newspaper lately.

A buffer is not a guarantee. It is a form of mitigation that reduces the impact once a risk event crystalises on the balance sheet. No account is taken of credit issuance from ratings obtained through risk capital, nor the effect of moral hazard. In the end the mechanisms in place that prevented systemic collapse are the same ones that have attempted it in previous crises. Those are the reserve and transmission mechanisms of the public purse.

Honestly ...
For me the only reason is your innate desire to kill the Euro and to remove any success that comes outside from the Anglo-Saxon world. And also, that all rating agencies (Moody's, Fitch) belong to the decrepit Anglo-Saxon world. China emerges as world power and is already moving in Latin America and Spain to the United States and his errand boy in Europe (UK).

You have runaway inflation, your economic growth is negative and above now also increases your debt. It seems as if your island is sinking and perhaps wish to obtain assistance from the FMI. I do not understand is that your debt remains AAA and Spain in A-

No, I think it is good when "foreigners" have a critical view on other countries.

I miss your point, exactly because of the mileuristas these houses are build. It is the idea of facilitating those families a less expensive home.

The other homes (hundreds of thousends) are on the free market. There is no state intervention to lower the prices. The housing market bubble was financed via bank loans which were mostly sold to investors. This is called in banking CLOs. Banks repackage the loans and sell it to investors. Do you know which investors bought most of these financial products? Germans and in a second place an Island called UK. So do not accuse Spain of not being aware of the housing market. Nobody was.

The figures are NOT cummulative. It as a year perspective. Spain was in 2009 ranked 7th.

It is not a question of pride. it is a question of facts. Just for your knowledge I am also a "foreigner"

Spain has AA rating not a single a- rating. Your list is great. Its more a wishlist. International companies ??, History of innovation. You said it: History. Car manufactoring has been sold (spain manufactures twice as much cars as UK). Banks are nationalised (No Spanish bank has been nationalised, Spanish banks by UK banks). Spanish utilities by Scottish power. Telefonica, Inditex, etc.. Even the merger of Iberia and BA was almost par.

But one thing is right. We suffer of a 20% unemployment. But even so we have less state deficit, less public debt and are starting to grow. UK´s AAA rating is a present. Don´t try to convince anyone that UK is the same as France (AAA rates) and by far it is not Germany (AAA). Enjoy your present.

I kind of agree with you on some of what you say. The UK is the US´s lapdog or whatever.. But you´ve got to sell yourself in this world, and there´s no shame in that. Here´s to being a lapdog for the Chinese and Indians too : you can still excerpt a litte influence now and again, even if it´s only peeing on the Masters leg from time ti time..

Agreed better if there was a European rating agency. But if there was, I think Europe´s Number One idiot Sr. Zapatero would want to try and influence how it worked and who was in charge! He would probably put one of his wise men Mousieur Deloir or ex Spanish President Felipe Gonzalez in the hotseat. Wow....

I don´t think there is an Anglo conspiracy at work here. Just some logic that takes a while sometimes to surface.
The Euro just doesn´t fit all these economies. The politicians did a bad job. It´s an aspiration, but they should have done it in a much slower gear over a period of decades. Spain, and it hurts me to say it, is one of the big longterm losers because of it.

Was it reckless lending, trading in toxic financial instruments or the lack of a sufficient capital base that led to the banking crisis ?

Shoring up the capital base is similar to closing the stable door after the nag has fled. Too much time and effort is been spent on fire insurance and greedy bankers bonuses.

Tackling the problem at its roots is to ring fence,outlaw or raise the bar on capital requirements for speculative trading activities so as to reduce them or ensure they are manageable risks.

The current crisis was not provoked by banks having a lower capital base. It was fueled by an unregulated,laissez - faire culture peddled under the guise that markets were sufficiently responsible and capable of self regulation. Many of the evangelists in the banking sector and regulators who touted actively this in the past are still in there !!.

The lack of strong regulatory controls on what banks (and shadow financial institutions) can do is more important than the amount of capital they hold.

Will we ever learn ? We did at our cost cleaning up the aftermath of the Great Depression then as memories faded so did the lessons and the circle is closed again. The 80 cycle mentioned is not an economic event but the inevitable consequence of travelling down the same route again and again.

But, sorry for seeming simple minded, if the risk is largely in the riskier elements of the unified or horizontally integrated Banks, why not install absolute firewalls between - say - three categories of business. (i) Consumer deposits and credit, (ii) lending based on a moderate percentage of an asset value where the asset is agreed to be subject to very slow depreciation and volatility in re-marketability lower than the loan as a proportion of original valuation - houses etc for consumers in good credit standing and such, and (iii) everything else.

We could surely set something close to the Basel III for category 1, markedly higher for the second, and even more for the third with an express state guarantee limited to something akin to the current Consumer Deposit Protection Scheme only for Category I deposits with express statutory non-guarantees for all other depositors and equity holders and in every case an in-built tidy method to wind-up any failing Bank.

Of course we'd need to see the HMG weaned from the disaster that's PFI, and some international treaties, but what the heck, more than doubling the equity of Banks will not work, and might well precipitate economic disaster.